A lot of people think that because a hedge fund is large they’re safer, but this is not so. If two hedge funds have the same leverage ratio, obviously the bigger one is more leveraged. Hedge funds have become so large that when managing a big one, it becomes hard to find a place for all the money. There are only so many overvalued and undervalued stocks in the world, depending on your strategy. In addition to this, for large hedge funds, position size becomes an issue. Simple demand and supply says that when demand for a share goes up, the price will rise. When an individual investor buys a share, this isn’t an issue, but when a large hedge fund tries to buy a share, their demand ALONE can shift the price up. When you’re trying to purchase a share cheaply this becomes a bit of an issue. It becomes even more of an issue when you’re trying to sell out of a position. Most hedge funds that go broke do so because they got caught with shares that were being punished in a crisis, and couldn’t sell out without causing the price to crash further. Even the most liquid markets can dry up for the largest of hedge funds. On top of this, once other hedge funds find out about your position, they tend to trade against you.
“Long Term Capital Management” (and a host of other failed hedge funds) found this out the hard way. Their strategy involved taking advantage of tiny arbitrage opportunities. For example investors will tend to accept a lower interest rate on newly issued government bonds, because they tend to be more liquid than bonds near maturity. However, as the new bonds near maturity, the premium disappears and the bond price falls. By (short) selling the new bonds and using that money to buy the older ones, when the prices converge Long Term Capital Management make an almost riskless profit. Unfortunately the profit might only be three percent of the value of capital used. For this strategy to bring in reasonable profits massive amounts of leverage were required. Taking into account leverage can really deflate the “spectacular” returns posted by hedge fund managers. A thirty percent return might sound pretty good, but with five times leverage this amounts to a six percent return on assets held, slightly more than you can get on a savings account right now! And considering the average return on the ASX 200 is around twelve percent, nothing to crow about.
The next lesson Long Term teaches us is the danger of such leverage. Leverage of 17.5 times turned a 2.45% profit into 42.8% in 1995, but Long Term thought that this wasn’t an issue due to the “riskless” nature of arbitrage. But when Russia defaulted on its debt this set off a wave panic which set all investors’ minds on running to safe havens. Logic and valuation took a back seat (as it often does in a panic) and so arbitrage strategies like Long Term’s, which rely on investors bringing price anomalies (like mispriced treasuries) into line, started to go wrong. Worse still everybody knew it. Hedge funds began to trade against Long Term, sending the spreads wider between securities that Long Term was betting would get smaller (and vice versa). They hoped that eventually Long Term would lose enough money that they would have to unload their positions, pushing themselves (Long Term) further into the red as they sold, and increasing the profits for the other hedge funds.
Leverage reduces the necessary loss that will put a hedge fund out of business. If your leverage ratio is one (ie no borrowing) you need a loss of one hundred percent to finish you (not counting that investors will start pulling their money out before this). If your leverage ratio is five, you can only lose 20% (a fifth), and if your leverage ratio is 17.5, a 1/17.5 or 5.7% fall in the value of your assets will ruin you. What’s more, your creditors will be watching your leverage ratio skyrocket. If you start with a leverage ratio of five, and then you have a five percent drop in your assets, without any further trading, your leverage ratio creeps up to 6.33. A seven percent loss brings it up to 7.15 times. And a ten percent loss drives your leverage ratio up to 9 times (giving a debt equity ratio of 800%). And the higher it gets, the more nervous lenders get, and the more of your capital they demand in order to continue extending your loans. Eventually lenders decide enough is enough and force the hedge fund manager to liquidate his holdings and pay the loans back. Game over.
